Common Franchise Disclosure Document Mistakes

06/24/2014

As an attorney who represents franchisors, a significant part of my practice is drafting franchise agreements and franchise disclosure documents. Once these documents are completed, I also help franchisors comply with state laws by filing and maintaining their registrations in the various states that have franchise registration laws. As a result, much of my time (particularly during the first half of the year) is spent dealing with franchise regulators in various states.

During my years of practice, I have seen a number of common mistakes made by both start-up and established franchisors in their Franchise Disclosure Documents (“FDDs”). Many of these mistakes, which can cause delays in a franchisor’s ability to obtain registration, are easily avoided. Make them, and state regulators will refuse to register your franchise offering – sending you a comment letter requiring you to correct your errors before issuing a registration permit. Avoid them, and your time to obtaining registration may be cut down by weeks, or even months.

A common FDD mistake is failure to list all “Other Fees” in Item 6. Item 6, entitled “Other Fees,” is where a franchisor must disclose all fees, other than initial fees, that are paid to or imposed by the franchisor. Specifically, in Item 6 a franchisor is directed to disclose “all other fees that the franchisee must pay to the franchisor or its affiliates, or that the franchisor or its affiliates impose or collect in whole or in part for a third party.” The franchise company must list the type of the fee, state the amount (either a fixed amount or a formula used to determine that amount), state the due date, and make any remarks, definitions, or caveats regarding the fee.

Many franchisors do not follow instructions and fail to list all “other fees” in Item 6. These mistakes typically come in two varieties.

1. Common Mistake #1: Failure to List All “Other Fees” Paid to the Franchisor or its Affiliates

The first type of mistake is that the franchisor or its counsel fails to list all of the fees that could be charged during the life of the franchise according to the franchise agreement. In these situations, the franchisor may list only the more “obvious” fees like the royalty fee, advertising fund fee, technology fee, and the like – the fees that are typically identified in a section of the franchise agreement devoted specifically to listing fees.

The problem with this approach is that often, a number of other possible payments are hidden within other section of the franchise agreement, and these amounts clearly fall within the definition of “other fees” in Item 6.

There can be a multitude of fees charged that may be hiding in the franchise agreement but need to be disclosed in Item 6. Some examples:

The franchisor charges a “relocation fee” in the event that the franchisee wants to relocate the franchised business.

The franchisor charges a mark-up fee if the franchisor is required to obtain insurance for the franchisee, because the franchisee failed to purchase insurance on its own.

If the franchisor conducts an audit of the franchised business that shows the franchisee has understated its gross revenue to the franchisor, the franchisor charges the franchisee for the cost of the audit (in addition to the other rights that it retains under those circumstances).

The franchisor charges a fee for the franchisee to send a replacement manager to attend the franchisor’s initial training program.

The franchise agreement has a liquidated damages provision that requires the franchisee to pay a set amount if the franchise agreement is terminated early due to the franchisee’s material uncured breach of the contract.

The franchisor requires the franchisee to pay for or reimburse the franchisor for the cost of advertising, marketing or promotional materials provided by the franchisor.

This is only a partial list of the types of fees that can fall under the category of “other fees.” I have seen many FDDs where franchisors will clearly charge these fees, but fail to list or disclose them in Item 6.

06/04/2014

As an attorney who represents franchisors, a significant part of my practice is drafting franchise agreements and franchise disclosure documents. Once these documents are completed, I also help franchisors comply with state laws by filing and maintaining their registrations in the various states that have franchise registration laws. As a result, much of my time (particularly during the first half of the year) is spent dealing with franchise regulators in various states.

During my years of practice, I have seen a number of common mistakes made by both start-up and established franchisors in their Franchise Disclosure Documents (“FDDs”). Many of these mistakes, which can cause delays in a franchisor’s ability to obtain registration, are easily avoided. Make them, and state regulators will refuse to register your franchise offering – sending you a comment letter requiring you to correct your errors before issuing a registration permit. Avoid them, and your time to obtaining registration may be cut down by weeks, or even months.

A common FDD mistake is failure to list all “Initial Fees” in Item 5. Item 5, entitled “Initial Fees,” is where a franchisor must disclose all initial fees paid by the franchisee, and the conditions under which the fees are refundable. “Initial Fees” are defined as “all fees and payments, or commitments to pay, for services or goods received from the franchisor or any affiliate before the franchisee’s business opens, whether payable in lump sum or installments.” A franchisor must also disclose whether the initial fees can be paid in installments, and what those payment terms are.

Many franchisors do not follow instructions and fail to list all initial fees in Item 5. These mistakes typically come in two varieties.

1. Common Mistake #1: Failure to List All Initial Fees Paid to the Franchisor

The first type of mistake is that the franchisor or its counsel assumes that “Initial Fees” means only the initial franchise fee paid by the franchisee (the fee franchisors charge franchisees for the right to enter into a franchise agreement). This is wrong because it ignores the other types of fees that are paid (or that the franchisee is committed to pay) to the franchisor prior to the franchisee’s business opening.

In some franchise systems, there can be a multitude of initial fees charged that need to be disclosed in Item 5. Some examples:

In connection with processing the franchisee’s application (running credit, doing a background check, etc.), the franchisor requires a deposit or “application fee.”

The franchisor charges a fee for the franchisee to attend initial training.

The franchisor requires (or has the right to require) the franchisee to pay a fixed amount directly to the franchisor so that the franchisor can conduct grand opening advertising for the franchisee.

The franchisor charges a technology start-up or other type of fee relating to the franchisee’s use of the franchisor’s point of sale or other software system.

This is only a partial list of the types of fees that can fall under the category of “initial fees.” I have seen many FDDs where franchisors will clearly charge these fees, but fail to list or disclose them in Item 5.

2. Common Mistake #2: Failure to List All Initial Fees Paid to the Franchisor’s Affiliates

The second type of common mistake is the franchisor lists only initial fees paid by the franchisee directly to the franchisor, but ignores the fees paid to the franchisor’s affiliates. The instructions for Item 5 clearly call for these fees to be disclosed, too. Remember, an “affiliate” is defined as “an entity controlled by, controlling, or under common control with, another entity.”

Some examples of fees paid to a franchisor’s affiliates:

The franchisee must purchase an initial stock of inventory from the franchisor’s affiliate.

The franchisor’s affiliate builds out the store for the franchisee (often referred to as a “turn key” franchise), and the franchisee pays the affiliate for the build-out.

The franchisee is required to pay the franchisor’s affiliate to buy or obtain the right to use the franchisor’s proprietary software system.

The franchisee buys an initial supply of marketing materials from the franchisor’s affiliate.

Again, these are just some examples of the types of fees that are paid to affiliates. If these fees are paid before the franchisee opens for business, they are “initial fees” and must be disclosed in Item 5.

Conclusion

Avoid making these common mistakes in Item 5 of your own FDD, and you will have an easier time of getting registered in the registration states.

05/27/2014

As an attorney who represents franchisors, a significant part of my practice is drafting franchise agreements and franchise disclosure documents. Once these documents are completed, I also help franchisors comply with state laws by filing and maintaining their registrations in the various states that have franchise registration laws. As a result, much of my time (particularly during the first half of the year) is spent dealing with franchise regulators in various states.

During my years of practice, I have seen a number of common mistakes made by both start-up and established franchisors in their Franchise Disclosure Documents (“FDDs”). Many of these mistakes, which can cause delays in a franchisor’s ability to obtain registration, are easily avoided. Make them, and state regulators will refuse to register your franchise offering – sending you a comment letter requiring you to correct your errors before issuing a registration permit. Avoid them, and your time to obtaining registration may be cut down by weeks, or even months.

The Disclosure Requirement

On the top of the list of these common FDD mistakes is the franchisor’s failure to comply with the requirements for Item 2. Item 2, entitled “Business Experience,” is where a franchisor must list employment history of certain of its key officers, managers, directors, and employees. The instruction for completing Item 2 is a simple one:

Disclose by name and position the franchisor’s directors, trustees, general partners, principal officers, and any other individuals who will have management responsibility relating to the sale or operation of franchises offered by this document. For each person listed in this section, state his or her principal positions and employers during the past five years, including each position’s starting date, ending date, and location.

That’s it – that is the entire instruction for Item 2. The instruction does not call for the franchisor to give the entire resume, or even a mini biography, for its key personnel. But that’s exactly what many franchisors tend to do.

Common Mistakes in Item 2

The franchisor’s natural tendency in Item 2 is to use it as a sales tool – explaining why and how its key people are well-qualified, outstanding individuals with a long history of leading successful companies, and why they are great human beings, to boot. Here’s an example of how a non-compliant, overly-descriptive Item 2 might look:

Jules Winnifield, President

Jules has been the President of Jack Rabbit Slim’s Franchising Company for six years, and has been the driving force behind growing our franchise system from two locations to seventy-five. Before coming to work for Jack Rabbit Slim’s, Jules was the Chief Operating Officer of Red Apple Security, one of the largest private security companies in the world. During his eight years at Red Apple, Jules was responsible for a 22% increase in revenue company-wide. Jules earned his Ph.D in Behavioral Psychology from the University of Santa Cruz in 1992. In addition to his hobbies, which include walking the earth and memorizing passages from important works of literature, Jules enjoys spending time with his wife, Mia, and his children, Marsellus and Lance.

So what’s wrong with the above description? A lot. First, it provides only a small portion of the information called for by the instructions in Item 2. While it does at least describe where Jules has been employed for the last five years, it doesn’t tell you the dates of employment or where those positions were located. Second, the listing reads like a sales pitch, telling the prospective franchisee why Jules is so well-qualified for his current position. Nothing in the instructions for Item 2 asks the franchisor to provide that information. Third, the franchisor has provided more than five years of work experience for Jules, going back more than thirteen years into Jules’s prior employment. Fourth, the Item 2 instructions do not call for educational experience – only work history. And in this situation, it’s not even clear that Jules’s doctoral degree is even relevant to his current line of business. Fifth, nothing in the guidelines asks a franchisor to provide information regarding the hobbies or family members of its key personnel.

You might think I’m exaggerating non-compliance with Item 2 when I list Jules’s hobbies, wife and children. I’m not. I’ve seen many franchisors provide exactly that type of information in Item 2 of their own FDDs.

How An Item 2 Disclosure Should Look

Here’s how an Item 2 disclosure should look:

Vincent Vega, Chief Executive Officer

Vincent has been our Chief Executive Officer since March 2012. Prior to becoming our CEO, Vincent was President of Butch’s Boxing Club in Inglewood, California, a position he held between December 2010 and March 2012. Before that, Vincent was the Vice President of Operations for McDonald’s in Amsterdam, the Kingdom of the Netherlands, a position that he held between October 2006 and December 2010.

The above Item 2 description is correct because it provides all of the information called for by the instructions, and only that information. Vincent’s work experience the location of each position he held is listed in the description, and his starting and ending dates with each employer (month and year are all that is necessary) are given. The disclosure gives enough information to cover his last five years of employment, and no more.

Conclusion

Avoid making these common mistakes in Item 2 of your own FDD, and you will have an easier time of getting registered in the registration states. While it may be tempting to include the extraneous information in Item 2, your doing so will increase the likelihood that you will obtain comment letters from those states, and that your registration will be delayed as a result.

Matthew Kreutzer is a Partner at Howard & Howard Attorneys and serves as Chair of the firm's Franchising, Distribution, and Antitrust Practice Group. Mr. Kreutzer, who is based in the firm's Las Vegas office, is a Certified Specialist in Franchise and Distribution Law by the State Bar of California's Board of Legal Specialization.

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This blog is dedicated to advancing the franchising industry through the sharing of business, legal, and practical information and ideas. This blog is a service of Howard & Howard's Franchising, Distribution, and Antitrust Practice Group.